The Federal Reserve has a seemingly odd fear about the markets that may appear completely upside down to most investors – but this fear is so serious it is helping to determine the Fed's actions, even as it poses a potentially acute risk for investors. As reported in MarketWatch on February 19th, there was a wide ranging discussion at the January, 2015 meeting about if and when to raise interest rates, and this was part of the discussion:

"Fed members who supported an early move said they were concerned that holding rates low for too long might lead to asset bubbles."

So the Federal Reserve is not raising interest rates in the near term, because the economy is still too fragile and weak to handle interest rates above (effectively) zero percent. Yet what they also fear is that this weak economy will generate stratospheric market prices (i.e. asset bubbles) that could be prone to sudden collapse, which could pose acute risks to the economy, global stability, and investment returns.

That may all sound counterintuitive, as it would seem to make sense that a weak economy should naturally lead to weak markets and falling prices, whereas it's a strong and healthy economy that should create rapidly rising market prices.

However, as explored by some prominent global economists in the recent e-book, "Secular Stagnation: Facts, Causes and Cures", edited by Coen Teulings and Richard Baldwin, the creation of financial bubbles may indeed be the quite likely and expected result of current government policies around the world for dealing with stagnant economies and persistent unemployment. Indeed, the term "rational bubbles" is used to explain the rational reasons for why weak economic times are particularly likely to create irrational prices that foster financial instability.

This then raises an interesting and quite timely question: is the Standard & Poor's 500 stock index above 2,000 and the Dow above 18,000 in spite of still weak economic growth and persistent unemployment problems? Or are stock markets soaring to record levels specifically because of the underlying problems and the government's interventions which attempt to fix those problems?

Most investors would likely agree that with stock indexes in record territory, it is critically important to be able to distinguish between whether the source is 1) the rational result of a thriving economy; or instead 2) the kind of financial bubble that can rationally be expected to be created specifically because of a persistently underperforming economy. So let's take a closer look at why it is that struggling economies can be expected to produce irrationally soaring stock markets and other financial bubbles.

Secular Stagnation & Bubbles

In a previous article, I discussed the general implications of an important new book released by the Centre for Economic Policy Research (CEPR), which suggests that the world has entered a "new normal" of secular stagnation (with secular being economics jargon for long term), with slow economic growth, an indefinite continuation of very low interest rates and – as a matter of deliberate governmental policy – persistent negative investor returns in inflation-adjusted terms.

The contributors to "Secular Stagnation" include Lawrence Summers and Paul Krugman, as well as numerous economists from such institutions as Harvard, MIT, Oxford, Cambridge, the International Monetary Fund and also the Principal Economist for the Executive Board of the European Central Bank.

However, while the face of secular stagnation is one of sustained and almost inescapable low yields – both for fixed income investors as well as the long-term economic growth which underlies rational stock market valuations – there is a glittering exception to this rule.

That is, what concerns these economists is that this environment of sustained very low interest rates combined with few good investment opportunities can be expected to foster the creation of financial bubbles and financial instability.

So that in the short term – and possibly even lasting for years – enormous paper wealth is created as a direct result of secular stagnation, until the bubble finally pops (as they always eventually do) at which time enormous economic and financial damage is inflicted on both investors as well as the financial system.

The danger is described by Lawrence Summers (Treasury Secretary in the Clinton administration, and former Director of the National Economic Council in the Obama administration) on pages 32-33 of the book.

"Low nominal and real interest rates undermine financial stability in variousways. They increase risk-taking as investors reach for yield, promote irresponsiblelending as coupon obligations become very low and easy to meet, and make Ponzifinancial structures more attractive as interest rates look low relative to expected growthrates. So it is possible that even if interest rates are not constrained by the zero lowerbound, efforts to lower them to the point where cyclical performance is satisfactorywill give rise to financial stability problems. Something of this kind was surely at workduring the 2003–2007 period."

Teulings and Baldwin considered the issue of "bubbles and low interest rates" to be one of the key new challenges created by secular stagnation (SecStag), and they devoted the entire third section of their introduction to the matter. The following quotations are from pages 13 and 14.

"Beyond ZLB issues, which have been the main concern in the SecStag discussion todate, low real rates can produce bubbles and foster financial instability – as Summersargues forcefully in his chapter. When the real rate, r, falls to values close to theeconomy’s growth rate, g, asset prices start to explode in a ‘rational’ way (as pointedout by Tirole 1985)."

"Bubbles are an alternative way for society to deal with excess saving when fiscal policydoes not take up the challenge. Buying bubbly assets with the intention of sellingthem at a later date is an alternative route of saving for future consumption. Whennobody wants to invest because r is below g, and hence buys bubbly assets, the price of these assets goes up, yielding windfall profits to their sellers who are therefore able to increase their consumption. This additional consumption restores the balance between supply and demand for loanable funds on the capital market."

"A greater supply of savings is one of the Wicksellian forces pushing the real interest rate down. Hence, ageing societies might run a greater risk of bubbles popping up."

To expand upon these brief quotations, there are several interrelated components which can work together in an environment of secular stagnation to create a financial bubble – or a series of financial bubbles.

While Central Bank interventions mean there is a large supply of low-cost money available to invest – where does one put it if we're looking at fundamental valuations?

Interest rates are very low and are indeed negative on an inflation-adjusted basis as a matter of quite deliberate governmental policy, as further explored here.

Economic performance is erratic at best, unable to deliver sustained and powerful economic growth, thereby eliminating much of the fundamentals-based premise for the valuation of stocks.

There just don't seem to be any good investment alternatives.

Another element – and one of the reasons why some believe that secular stagnation could be our indefinite future – is the globe's aging population, particularly in Europe, and to a lesser extent in the United States.

As the population ages, their economic productivity is likely to be falling, even as their consumption which drives future economic growth is also likely to be falling. Simultaneously, they have the largest amounts to invest in their latter years before retirement and in early retirement that they have ever had.

So productivity and consumption each fall while investable funds are peaking, thereby exacerbating the problem of a large supply of money seeking homes in what is otherwise a low yield environment.

And what happens as a result is that we get upward price movement in a given asset category.

As the prices climb upwards, this starts to produce a level of yields that are simply not available anywhere else. These attractive yields bring in new investors, which increases the prices, which then increases the yields while reinforcing the pattern, which in turn brings in the next round of money.

This pattern of rising prices drawing in money which fuels further rising prices – until rational valuations have been left far behind – is one of the oldest and most reliable stories in the history of finance and markets.

What is different this time around is the ready supply of cheap money, in combination with the lack of fundamental alternatives for investment, along with a large pool of older investors who are desperate for yield alternatives and are seeing attractive yields being created. While it may seem counterintuitive at first, these factors are all accelerants and in combination become the perfect recipe for creating a financial bubble.

And as discussed in "Secular Stagnation", these leading economists – whose policy advice is responsible for so many nations around the world adopting very low interest rate policies as an attempted cure for economic stagnation – are also perfectly well aware that these same economic strategies are creating an ideal environment for the creation and feeding of financial bubbles and financial instability.

Is Secular Stagnation The Source Of Current Stock Index Highs?

The 2nd half of this article explores:

1) The reasons to believe that current stock market levels are the result of a bubble rather than the actual condition of the economy

2) How central bank policies which create a combination of 1) low interest rates, 2) no premiums for risk and 3) the chance of bubbles – are a recipe for a potential nightmare scenario for retirement and other long-term investors.

This article contains the ideas and opinions of the author. It is a conceptual exploration of financial and general economic principles. As with any financial discussion of the future, there cannot be any absolute certainty. What this article does not contain is specific investment, legal, tax or any other form of professional advice. If specific advice is needed, it should be sought from an appropriate professional. Any liability, responsibility or warranty for the results of the application of principles contained in the article, website, readings, videos, DVDs, books and related materials, either directly or indirectly, are expressly disclaimed by the author.

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